Chairman's letters

14 November 2013

2013 Q3 Investor Letter (Extracts)

After five years of waiting, we can just about claim to have a global recovery, with GDP now growing at a respectable pace in the US, the UK and Japan, and even Europe enjoying a slow recovery. However, it is a recovery based on huge monetary stimulus from governments and central banks. Without this support, it looks fragile at best.

Furthermore, as growth has become increasingly dependent on government support, politicians across the globe have been able to increase their influence over their domestic economies. Given this trend, I was interested to read about a meeting of Chinese Hayekian economists in Beijing last month. Friedrich Hayek was a Nobel Prize-winning Austrian economist who argued that governments should have as little involvement in markets as possible, and that state economic control leads to tyranny. This group of Chinese economists suggested that China’s government should loosen its grip over the economy. Beijing is a particularly poignant place to have discussions about rolling back the frontiers of the state, especially since these ideas run counter to today’s global trend towards ever more state-driven economies.

We need to remember that ’advanced economies’ became advanced by rolling back the frontiers of the state in all areas of life. Today, however, governments are playing an ever larger role in markets, and populist politics are hampering sustainable economic growth in the most ‘advanced’ economies. In the UK, Ed Miliband, leader of the opposition Labour Party, has made a populist pledge to freeze energy prices if he comes to power, with no consideration for how the UK will pay for the new energy infrastructure it badly needs. Francois Hollande’s government in France has intervened aggressively with companies such as Peugeot and Arcelor Mittal when they have tried to shrink their French operations. In Germany, the Social Democrats have said they will not form a coalition with Angela Merkel’s Christian Democrats without changes such as the introduction of a blanket minimum wage law.

Even in the US, the ‘land of the free’, politicians on both the right and the left feel emboldened to put forward views on how they would interfere in the economy. Political involvement in economies today is far more significant than many people realise, and it is continuing to grow, rather than shrink.

Terra Firma has avoided investing in emerging markets because we cannot get comfortable with the high level of government involvement in the economies of those countries. There is certainly an opportunity for growth – since the start of 2010, over 75 per cent of global growth has come from the developing world – but I remain negative on investing in private equity in emerging markets because the risk of political instability concerns me. Without free markets and clear laws, international investors are likely to suffer disproportionately when economic activity goes in a direction the government does not like.

However, what is most worrying for international investors today is that the populist comments coming from politicians in Western countries sound increasingly like those one would expect to hear from developing nations. We have reduced politics to a competition that rewards those who can stir up the strongest emotions among the electorate in order to win votes, or at least air time.

In Europe, voters’ demands have inspired a surplus of economically naive and poorly designed populist policies. Meanwhile, in the US the Tea Party has had enormous effects. The Tea Party represents only a small minority of the country, yet by holding the country to ransom it nearly had a devastating effect on America and on the global economy.

Disaster in the form of a US default was narrowly avoided, but even with a just-in-time solution, Standard & Poor’s estimates that the 16-day government shutdown took $24 billion out of the US economy and may have lowered fourth quarter GDP growth by 0.6 percentage points. This is self-inflicted damage that the US can ill afford when it is still struggling with the legacy of the recent economic crisis, including high unemployment.

Even though mainstream Republicans and the Democrats finally came to an agreement, this only lasts until the beginning of 2014, when the debt ceiling will again need to be raised, and there is every reason to expect another showdown. This unfortunately seems to have become a permanent feature of the democratic process in the US, and as a result it is damaging America’s reputation around the world. During the shutdown, President Barack Obama cancelled his trip to Bali for the Asia-Pacific Economic Cooperation meetings, a very clear symbol of America being unable to influence global events while it is distracted by a crisis of its own making.

More than ever, America needs to work closely with Asia, rather than withdraw to focus on domestic problems. In the US there is a perception that China’s rise is America’s loss; however, it is important for American economic growth, and indeed that of the whole world, that China succeeds economically.

While double digit GDP growth may be a thing of the past, China’s economy continues to expand at a rapid pace. The challenge that China’s leaders now face is how to shift from growth based on government spending and construction to a more consumer-led economy that is less dominated by state-owned enterprises. So far they have struggled to make this transition, but it does need to occur if China is to reach its full potential in the longer term.

Meanwhile, the Chinese population’s expectations of living standards have been rapidly rising, but China’s slowing growth is unlikely to result in those expectations being met, and social unrest will increase. So far, China’s leaders have succeeded in channelling this unrest into other areas, such as rising nationalism in its territorial dispute with Japan. However, this has led to the South China Sea turning into one of the global hotspots for potential conflict, and it risks destabilising the whole area. In Japan, there is a very strong will among Prime Minister Shinzo Abe and his government to get the country onto a higher growth, higher inflation trajectory. This year has seen an extraordinary loosening of monetary and fiscal policy which does seem to be having a positive effect; however, I am far from confident that they will succeed in pushing through the more difficult aspects of their plan, the structural changes, which are the ones that really matter.

The Japanese population is relatively elderly, with the average age of a Japanese voter in the 2010 election being 56, while the 20-29 age group only accounted for 7.6 per cent of ballots. Any politician who wants to get elected is therefore likely to focus on the priorities of the older generation. Unfortunately for the young in Japan, these priorities are very different from those which are best for the country’s future. As a consequence, the government will struggle to make the structural changes that will lead to increased investment and growth. I expect that we will continue to see a slow, gentle decline in Japan, although it will likely be another 10 to 20 years before Japan’s economic condition becomes one of crisis. 

Against this backdrop, I continue to feel relatively positive on Europe. While there are certainly problems, such as the possibility of deflation in the periphery countries, investors became so negative on the region that these problems became exaggerated in the markets. Even with the market recovery this year, I believe that the risk is still incorrectly priced and that there are significant opportunities for private equity investment in Europe.

While investors are too negative on Europe, they are too optimistic on the US. In addition to the political uncertainty we have witnessed over the debt ceiling, the US has the intractable problem of health care which will increasingly drain the country’s coffers as the baby boomer generation ages. The World Economic Forum recently estimated that by 2040, healthcare expenditure could be nearly 30 per cent of GDP in the US. This is a major challenge which will require a co-ordinated response by US politicians, something that looks impossible today.

So while I expect the global recovery to continue, investors should not be blinded by rising GDP figures and rising stock markets. There are significant political risks in every global region, some of which could blow the global recovery off course, while others could just have more local effects. However, all are unpredictable and most will increase as the decade goes on.

As investors have become overly optimistic on the US and overly pessimistic on Europe, the resulting discount on prices in Europe relative to the US is helping fuel IPO activity. Around $20 billion in deals have priced in Europe this year, almost triple the amount from the same period last year. This is a very different picture from the US, where there have been almost $40 billion of new issues, which is almost unchanged from a year ago.

In spite of the political risks in Europe, this momentum in the market is a positive signal that investors are anticipating a pick-up in European economies. At Terra Firma we were able to take advantage of this impetus with the successful IPO of Deutsche Annington in July, for which there was significant investor interest.

This significant investor support reflects the strength of Deutsche Annington’s operations and its profitability, which Terra Firma has substantially increased through our intensive operational transformation of the business. Last month, Private Equity International recognised our operational achievements with Deutsche Annington by awarding us its Operational Excellence Award for 2013 in the European Large Cap category.

We did with Deutsche Annington what we do with all of our portfolio businesses – fundamentally transform the business and drive value by implementing our five key drivers: transforming strategy, strengthening management, investing in capital expenditure, building through mergers and acquisitions, and lowering the cost of capital to create extra upside. This is the consistent approach we have followed since Terra Firma was founded, with our Financial Managing Directors and Operational Managing Directors working side by side to maximise value in our investments.

As Terra Firma enters its twentieth year, we are more committed than ever to our strategy of investing in and transforming asset-backed businesses in essential industries. Though there are many risks to the current economic recovery, by maintaining our focus on operational change through a hands-on approach, we can continue to build successful businesses and generate value.

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